There are more than one spreads strategy making vertical spreads an umbrella. Vertical spreads are an options trading strategy that’s popular because of the protection offered. Employing this strategy will give you a higher probability of success and fixed risk while trading options! The most popular vertical spreads are credit spreads and debit spreads. Credits spreads are a selling strategy, while debit spreads are a buying strategy. Credit spreads don’t need to be as directionally biased as debit spreads.
Vertical spreads are the umbrella of trading spreads. The reason for this is that they house two different spreads strategies. They are debit and credit spreads. They consist of a combination of buying and selling a strike price within the same expiration. They are meant to limit risk over trading naked options.
Options have moving parts to them. Options strategies were developed as protection. The great thing about options is their ability to make money in any market.
Options can be confusing and overwhelming; especially to new traders. There are a few different names for each strategy; or so it seems.
For example, you can see bull put spread and bear call spread as well as debit spread, and credit spread. You’d see that and think they’re different strategies. However, they’re different names for the same strategy. Vertical spreads.
Although they have different goals and outcomes. That’s important to remember. Investopedia defines vertical spreads as the purchase of the same type of put or call option on the same underlying asset, with the same expiration date but with different strike prices.
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Options Basics
Before we get into vertical spreads, we need to understand what options are. Options give us the right but not the obligation to buy (call) or sell (put) a stock at a predetermined price within a set time.
One contract controls 100 shares. As a result, trading options is cheaper. You can grow a small account trading the higher priced stocks because you only pay a premium.
How many times do new traders turn to penny stocks to grow an account? With options trading strategies like vertical spreads, you can make money on large cap stocks while protecting yourself.
Hence the appeal of options. In fact, they have strategies for when the market is bullish, bearish or trading sideways.
Calls and puts are the most basic options strategy. They also make up every advanced strategy.
As a result, it’s important to learn how to trade calls and puts and what goes into their profit and loss potential. If that sounds overwhelming, don’t worry. We’ve got you.
The Credit Spread
There are two strategies that make up vertical spreads. The credit spread is one.
The credit spread strategy is when you buy and sell the same option with the same expiration date but different strike prices.
In other words, you’re trading two calls or two puts. They both expire on the same day, but their strike prices are different. You receive a credit into your account at the start of the trade.
Credit spreads can also be known as a bear call spread or a bull put spread. Knowing that can make it more confusing.
When you believe the stock is going to go down, place a bear call spread. When you believe a stock is going to go up, it’s a bull put spread.
It’s a bit of an oxymoron since calls are typically bullish and puts are bearish. Hence the need to practice trade and study.
Practice in a Simulated Account
Since options have so many moving parts to them, you’re going to want to practice trading them in a simulated account. ThinkorSwim by TD Ameritrade is one of our favorites.
With a paper trading account, you can place hundreds pf practice trades before using real money. As a result, you’re able to work out the kinks and see what options trading entails.
Trading is emotional as well. As a result, practicing allows you to learn to control those emotions. However, we realize that once you go live, it’s a whole different animal.
Losing money when you’re practicing is much less risky than going full throttle right out of the gate. It protects you as well as you learn how to sell a put.
The Debit Spread
The other components of vertical spreads is the debit spread. Money is initially debited from your account resulting in the debit spread name.
This is a directional strategy. As a result, you must choose the right direction. However, because you’re buying and selling a contract, you’re more protected.
Selling naked calls and puts don’t offer the same protection that vertical spreads do. Hence their popularity.
With this strategy, you want the amount of the options sold to be lower than the options that are purchased. As a result, you must pay the money up front.
Don’t worry if this sounds overwhelming. We have trading rooms where you can talk this through with other traders as well as our courses.
Options Chain
One of the reasons we’re focusing on vertical spreads is because of the options chain. By now you’ve realized there are more than one name for vertical spreads.
However, if you go to find credit spreads or debit spreads on an options chain, you’re going to be looking for a long time. They’re under the umbrella of vertical spreads.
How you place the trade that determines the type of spread you open. For example, when you sell a spread, it’s a credit spread. You’re receiving the premium of the trade.
When you buy a spread, it’s a debit spread. You’re paying money to place the trade. However, they’re both known as vertical spreads.
That’s why we want to pound this into you. Part of the difficulty of options are all the names for the same strategies. As a result, don’t get caught up in the minutia of it.
Instead, focus on what way makes the most sense to you and go from there.
What Happens to a Vertical Spread at Expiration?
Vertical spreads consist or both credit spreads and debit spreads. You should close out credit spreads at expiration to avoid potential assignment. Debit spreads are directional based so it’s best to take your profit before expiration, or cut your losses. The longer you hold the bigger your potential loss if the trade goes against you.
Practice Trading
Open a simulated trading account. That way you’re able to get familiar with the options chain, moving parts of options and how it all ties in together.
Don’t jump into the deep end without using floaties first. That can be one way to learn how to swim. However, we’re trying to protect our money.
“Using paper money isn’t the same”. How many times have we heard that? Of course, it’s true. Real money causes a lot more anxiety.
That’s to be expected. You have tangible results as a result of real money. However, practicing ahead of time helps to work out the kinks.
Vertical spreads are an advanced strategy. As a result, you need to plan your trade. Vertical spreads are less risky because they’re less expensive.
However, jumping in with real money and no experience is going to shake your confidence. Even if you start small. Sure, it’s only $30 here and there. But losing that adds up.
Practice doesn’t make perfect with trading. However, practice does allow you to test your strategy before putting skin in the game. That’s how you become successful.
The Umbrella of Vertical Spreads
Vertical spreads are the umbrella of trading spreads. Know that and you won’t be looking for credit or debit spreads on every options chain.
If you need more help, take our options trading course.
